Europe Macro – January 6, 2022

| January 6th, 2022

Today’s focus is on inflation. We cover the impact of inflation on wages in the UK, rapidly rising food inflation, and strong producer and consumer prices as a result of persistent energy inflation and supply chain issues. We also discuss what the uptick in German manufacturing orders means, and why “growth slowing” is back on the table.

1.  INFLATION

1.1 Britain should expect a fall in the value of real wages, not a wage-price spiral – The Times

[…] When inflation is rising faster than pay, it means only one thing: falling real wages. A few months ago, something remarkable appeared to be happening to earnings growth, which hit almost 9 per cent in the spring of last year. This sparked some demonstrable nonsense from the prime minister, who claimed that employers had been drunk on cheap foreign labour and that the UK was transforming itself into a high-wage economy. Yet it was always clear that these figures were heavily distorted both by the furlough scheme and by so-called compositional effects — the absence from work of many people in low-pay sectors such as hospitality. I wrote here that earnings growth would slow as the year went on, and it has, dropping to roughly 4 per cent, with probably a little further to go.

Predicting a fall in real wages is one of those things that, to paraphrase Nye Bevan, you do not need to look into the crystal ball when you have the history. Real earnings, on both a total and regular pay basis, were lower in October, the latest official figures, than at the end of 2020 and there is a bigger squeeze to come.

Longer-term history does not offer much more comfort. Total weekly pay in real terms was slightly lower last autumn than in early 2008, before the financial crisis struck. There have been ups and downs over that period, including a temporary real pay revival in the mid-2010s, which was soon snuffed out, but this adds up to 13 lost years for real growth in pay.

The pandemic has not changed that, nor provided the elixir of productivity growth essential for rising real wages. But it has changed one thing. One reason that the coalition government of 2010 and the Tory government of 2015 were obsessed with raising income tax allowances and thresholds was to ease the squeeze caused by stagnant real wages. Those allowances and thresholds will be frozen from next April, so no such comfort will be available. The best hope now is that the inflation surge is as short-lived as possible.

Comment: David Smith is raising an important question. What if wage inflation isn’t happening despite high inflation? In the US, a high number of vacancies is increasing wage inflation. In the UK, that’s not the case:

“We should be careful about concluding that a large number of vacancies equates to wage pressure. There are many vacancies in hospitality, 165,000 at the latest count, a sector that is struggling under the impact of Covid. There are also large numbers in the public sector, where pay is subject to government constraints.

Some people are achieving higher pay by changing jobs, but pay increases remain moderate, even amid rising inflation. The days of inflation-plus pay settlements, once insisted upon by unions, are long gone. According to XpertHR, which monitors settlements, the median increase in the three months to November was 2.2 per cent, lower than before the pandemic. Settlements probably will go higher this winter, but they will not go as high as inflation.”

The following chart shows average weekly UK wage growth, which increased 4.9% in the three months to October 2021:

It can also be assumed that many companies are not in a great position to raise wages, which indeed means that inflation needs to come down to alleviate some of the pressure currently hurting the consumer as UK GfK consumer confidence remains below pre-pandemic levels:

1.2 Food prices rise at fastest pace since pandemic began – The Telegraph

Supermarket prices are rising at their fastest rate since the pandemic struck in a further blow for cash-strapped shoppers. Food prices jumped by 3.5pc last month compared with a year earlier, adding £15 onto the bill of the average shopper, according to data experts Kantar.

It is the highest rate recorded by Kantar since the onset of the pandemic when householders were panic-buying essentials, forcing supermarkets to impose limits on certain items. Prices climbed the fastest in categories such as fresh beef, savoury snacks and skincare, but fell in fresh bacon, bath and shower products and spirits.

Fraser McKevitt of Kantar said: “We saw prices rise faster for a short while in spring 2020 when promotions were cut to maintain product availability, but before that you would have to go back nearly four years to January 2018 to see inflation running higher.”

It came as visits to supermarkets hit their highest level since March 2020, as consumers brushed off fears over the omicron variant. Food manufacturers and supermarkets have warned that consumers face higher prices as they grapple with rising transportation costs and a shortage of lorry drivers.

Last month, the Bank of England revised up its inflation forecast to predict consumer price inflation would peak at a 30-year high of around 6pc in April.

Grocery inflation stood at 2.7pc for the 12 weeks to Dec 26, Kantar said. Meanwhile, total grocery sales were £31.7bn over the same period, down 3pc compared to 2020, but up 8pc on 2019.

Comment: Food inflation and global food insecurity are key topics in 2022 (and beyond). In the UK, food inflation is heating up. 3.5% food inflation last month means the trend is up. And that’s no surprise for a number of (interconnected) reasons. One of them is lower exports from key producers.

Russia, the world’s biggest wheat exporter, said it will impose a wheat export quota of 8 million tonnes for the period from Feb. 15 to the end of June. The quota is in addition to Russia’s floating-rate wheat export tax enacted last June that has curbed year-over-year exports of the grain by about 30% since the July start to this marketing year.

The export quota, intended to quell Russia’s domestic food price inflation, could force wheat importers to increasingly seek out supplies from other major producers, including the US and Australia. But with ending wheat stocks globally at their lowest level in 14 years, a shift in international trade flows could continue to exert upward pressure on wheat prices, raising input costs for a host of food manufacturers, from bakeries to breakfast cereal makers.

Since July 1, FOB export prices are up 38% for milling wheat from the Black Sea region, which includes Russia and Ukraine. Russia’s wheat export tax compounds FOB price gains, helping to explain the country’s sharp drop in wheat exports. By comparison, FOB export prices are up 30% for hard red winter wheat shipped from US Gulf ports. 

Moreover, CBOT corn and soybean futures are accelerating again, which will put pressure on producers to hike prices in 1Q22 – most of them were planning on doing this anyway to deal with higher input inflation in 2021.

And on top of this, we should expect lower crop yields in 2022 as farmers have either no access to sufficient fertilizer or they buy less because of rapidly rising prices. All things considered; food inflation is set to become a recurring topic in this newsletter.

1.3 Rise of up to 66 per cent: Producer prices in the euro area climb at record pace – Handelsblatt

Manufacturers’ prices in the eurozone are rising faster and faster due to expensive energy. Producer prices of industrial products rose by a record 23.7 percent year-on-year in November, Eurostat, the statistics office, said on Thursday.

Economists polled by Reuters had expected only 22.9 per cent, down from 21.9 per cent in October. Energy alone saw a massive increase of 66 per cent. Excluding this sector, producer prices rose by just under ten per cent overall.

Producer prices are considered an early indicator for the development of inflation. In the statistics, prices are recorded ex-factory – i.e. before the products are further processed or go on sale. They can thus give an early indication of the development of consumer prices.

Inflation is currently on the rise in the euro area and has shot far above the European Central Bank’s (ECB) target of two per cent. Fuelled by massive increases in the cost of oil and gas, consumer prices climbed by 4.9 per cent in November within a year – the highest level since the beginning of monetary union. The December data will be published on Friday. Experts expect a slight decline to 4.7 per cent.

Comment: Another piece of news that’s not transitory. Inflation is here to stay for multiple reasons: supply chain problems are persistent, energy markets are far from going back to normal, and climate measures like carbon credits and related are set to make inflation persistent. 

The only thing that could give producers some temporary relief is energy. After rising to EUR 180 per KW/h, Dutch TTF natural gas benchmark prices fell hard, but have quickly rebounded and are hovering close to EUR 100. While it’s well-below the pre-Holiday peak, it’s far from sustainable and roughly 5x higher compared to pre-2021 levels.

One major reason for lower prices in recent weeks is warmer weather. As north-western Europe including the archipelago experienced a period of exceptionally warm temperatures at the end of December and the start of January. In recent days, temperatures have fallen significantly as the warm spell gives way to a colder one, with temperatures much closer to the seasonal norm or even slightly below. But overall, the first half of winter has been significantly warmer than average, reducing heating demand and gas consumption, easing pressure on unusually low gas inventories, and arresting upward pressure on gas and electricity prices:

London temperatures are similar:

However, Europe is not out of the woods yet – far from it. Russian natural gas exports continue to be low, and weather is expected to become colder. Over the past few days, natural gas storage increased for four consecutive days. That’s unique. Yet, total storage remains at one of the lowest levels ever as the graph below shows. There was improvement, but the bigger picture remains grim, which is why inflation is unlikely to get any downward pressure from energy anytime soon.

1.4 Inflation in Germany rises to 5.3 per cent in December – Handelsblatt

Prices in Germany continue to rise. In December, the inflation rate in this country was 5.3 per cent, as the Federal Statistical Office announced on Thursday on the basis of a preliminary estimate. In November, prices had risen by 5.2 per cent – the highest rate since the boom after reunification in 1992.

Inflation in the euro area has also risen significantly recently. In November, it was 4.9 per cent, the highest level since the beginning of monetary union. The European statistics authority Eurostat will publish the rate for December tomorrow, Friday morning.

Inflation is causing controversial debates among economists and on the financial markets. In December, the Bundesbank significantly raised its forecast for Germany. According to the European calculation method of the harmonised consumer price index (HICP), it expects an inflation rate of 3.6 per cent for this year, after previously assuming 1.8 per cent.

The European Central Bank (ECB) also increased its forecast significantly. However, it continues to attribute the increase primarily to special effects caused by the pandemic, especially supply bottlenecks, catch-up effects in consumption and the reversal of last year’s VAT cut in Germany.

Comment: Consumer prices in Germany continue to rise. Finance minister Christian Lindner said that “we are closely monitoring development of inflation”. Some commented that the ECB is right because inflation is falling. They base their assumption on harmonised consumer prices, which increased by 5.7% in December. That’s down from 6.0% in November. Yet even if inflation comes down, the odds are against a normalisation towards 2% inflation. It would be dangerous if the ECB were to rely on harmonised prices. Even prolonged inflation rates close to 3-4% (well above the ECB target of 2%) would be devastating in a zero/negative-rate environment.

2.  SUPPLY CHAINS

2.1 German industry orders unexpectedly pick up significantly – Handelsblatt

German industry recovered more strongly than expected from the previous slump in orders in November thanks to strong foreign demand. Companies netted 3.7 per cent more orders than in the previous month, the Federal Statistical Office reported on Thursday.

Economists polled by Reuters had expected growth of only 2.1 per cent. In October, there had been a decline of 5.8 per cent. “This provides a positive impulse for the economic outlook, although economic activity continues to be burdened by existing supply bottlenecks,” the Federal Economics Ministry said.

The positive performance in November was solely due to the increase in foreign demand: orders from abroad rose by 8.0 per cent compared to the previous month. Orders from the euro zone rose by 13.1 per cent, while orders from the rest of the world climbed by 5.0 per cent.

Domestic orders, on the other hand, fell by 2.5 per cent. Sales in industry also developed positively in November: they were 4.2 per cent higher in real terms than in the previous month but remained 3.4 per cent below their pre-crisis level of February 2020.

Comment: Higher-than-expected new orders in November are good news. However, it’s just a part of the story. For example, due to a very poor new orders performance in October, new orders growth in November is not able to make new highs. Also, supply chain issues continue to make it nearly impossible for companies to turn orders into sales, resulting in lower-than-expected growth in 2022:

“The shortage of materials in industry worsened again at the end of 2021: 81.9 percent of companies complained about bottlenecks and problems in the procurement of intermediate products and raw materials, more than ever before. Since the problems are likely to continue for a while, the upswing this year will be smaller than previously assumed, according to forecasts by leading institutes. The Kiel Institute for the World Economy (IfW), for example, lowered its forecast for gross domestic product growth in 2022 from 5.1 to 4.0 per cent.”

Additionally, as Markit reported this week, new orders growth (in December) is showing a significant growth slowing trend:

“Inflows of new orders at German manufacturers continued to outstrip production volumes, leading to another steep increase in backlogs of work in December. The rate of new order growth lost further momentum, however, easing to its lowest since the current upturn began in July 2020.”

And it’s not just Germany. In the United Kingdom, we’re witnessing that a majority of companies will hike prices over the next three months:

“According to a poll from the British Chambers of Commerce, 58 per cent of firms expect to charge their customers more for goods and services over the next three months, 1 per cent anticipate cutting prices.”

The data, published by The Times, also highlights slowing capital expenditures due to uncertainty and lower profit margins. This would explain weakness in German new orders, which are highly dependent on (foreign) capital investments.

“Rising inflation would cloud the economy’s growth prospects this year by reducing consumers’ spending power and squeezing firms’ profit margins and limiting their ability to invest, the BCC added.

The survey showed that investment in plant, machinery or equipment flatlined in the fourth quarter. Some 29 per cent of respondents said they had invested more during the period, with 60 per cent reporting no change, and 11 per cent cutting investment.

Shevaun Haviland, director general of the BCC, said: “Our latest survey paints a challenging picture for the UK economy as we start 2022.””

In the EU, we’re now witnessing what could be the start of a growth slowing cycle. It needs to be seen what happens when supply chain issues ease, but for now, the slowing trend in new orders is worrisome.

2.2 EU fight over carbon allowances sharpens ahead of new tax talks – Financial Times

This year will be crucial for the EU’s attempts to export its environmental policies to the rest of the world (see: the taxonomy), writes Andy Bounds in Brussels.

One of the blockbuster policies to be negotiated in the coming months is the EU’s carbon border adjustment mechanism — a tool that will force foreign importers to pay a CO2 price equivalent to EU businesses. It is designed to prevent polluters from simply decamping to less onerous jurisdictions to avoid paying the price for carbon.

The European parliament’s environment committee wants the CBAM, due to come into force from 2026, to be introduced sooner and on a wider range of imports. Dutch Labour MEP Mohammed Chahim outlined his draft report yesterday.

One of the most contentious parts of the CBAM is how quickly to phase out free carbon credits awarded to EU industries that pay Europe’s domestic CO2 price. The introduction of the CBAM is meant to help level the playing field between EU and non-EU producers of electricity, steel, cement, iron and fertiliser, thus removing the logic for free allowances.

The European Commission’s draft text, published last summer, proposed a gradual phaseout from 2026 onwards, with 2036 the year in which all free credits are removed.

In his report, Chahim sought to shorten this phaseout to allow the CBAM to kick in earlier. European industries such as steel are big beneficiaries of free carbon credits, whose price reflects the now-record cost of CO2, which hit €90 a tonne last month.

Chahim wants the phaseout to start in 2025 and be entirely eliminated at the end of 2028. “Free allowances have had their uses in the past but with the introduction of CBAM, we have an alternative carbon leakage measure,” Chahim told Europe Express.

EU governments wary of the merits of the CBAM will push for longer timelines to protect industries from the soaring cost of polluting, with steelmakers already intensifying lobbying. Member states will have to agree on their position before final negotiations with MEPs this year.

Comment: One of the most neglected issues when discussing CBAM is “greenflation”. Because of higher carbon prices, production in the EU becomes more expensive as we discussed in an in-depth piece yesterday. Now, companies cannot offshore production or use cheap imports as carbon will be taken into account when importing products under CBAM. Moreover, foreign countries are upset as it lowers the attractiveness of their export markets in the EU while EU countries continue to export “polluting” products into countries with less strict carbon rules.

3.  ENERGY/CLIMATE

3.1 Germany’s green-on-green wind power battle – POLITICO

Germany’s new government is planning on doing something that’s certain to enrage some of its keenest environmentalist supporters — dramatically expand wind power.

The government aims to build between 1,000 and 1,500 new wind towers a year — breaking a red tape logjam that had blocked many projects as a result of local resistance often couched in terms of protecting the environment, birds or beautiful views. That means up to 2 percent of the country will be covered by new wind projects.

The job of balancing the need to swiftly build up renewable energy while also preserving nature falls to Steffi Lemke, the new environment minister.

“My aim is to propel nature-based solutions,” she told POLITICO, adding: “I want to tackle both biodiversity loss and the climate crisis in the coming years, as we need to address these two issues together.”

It’s not going to be easy.

Wind power is crucial to Germany’s economic future as the country powers down its last nuclear reactors, which last year generated about 12 percent of its electricity. Three were shut down last week and the final three will close this year. The new government has also committed to scrapping coal-fired power by 2030, speeding up the previous timeline of exiting coal — which generated about a quarter of Germany’s power last year — by 2038.

But onshore wind also arouses fierce opposition, which is why Bavaria passed its 10H law, mandating that a wind tower has to be 10 times its height, measured from the ground to the tip of the turbine blade, from the nearest residential building. That’s made new wind developments in the state almost impossible.

Accelerated planning — including in the area of renewable energy — “cannot go at the expense of nature and species protection,” said Jörg-Andreas Krüger, president of the Nature and Biodiversity Conservation Union of Germany (NABU), an NGO that used to be at the forefront of suing wind energy projects for their failure to sufficiently protect endangered species and only recently warmed up to the idea of expanding wind energy.

[…] “In addition to the climate crisis, a second major ecological crisis is fermenting with the extinction of species — not exactly a cuddly question either. We have to bring the economy and the climate, the environment and agriculture together,” Habeck, the deputy chancellor, told Süddeutsche Zeitung.

Comment: Instead of admitting that the German energy transition has become a mess, the new government is doubling down on wind energy. Moreover, as we discussed on Tuesday, the Greens are looking to join the Austrian Greens in suing the EU Commission over its decision to include natural gas and nuclear energy in the green taxonomy. 

This means that the first thing the Greens are doing is dealing with enraged environmental organisations – imagine that. 

The uncomfortable truth is that the situation is even worse according to WELT as high wind energy demand is causing massive timber production overseas (i.e., Ecuador):

“Balsa wood, which is on the one hand very flexible and hard, but on the other hand very light and strong, is used to build the ever-lengthening rotor blades of wind turbines. Around 150 cubic metres of wood are needed for a rotor blade between 80 and 100 metres long. Not all wind turbines rely on balsa wood; recycled plastic is also used as an alternative.

The massive logging leads to ecological collateral damage. Animals that depend on nectar as a food source are particularly affected in the region, reports biologist Álvaro Pérez from the University of PUCE to Ecuadorian media. Meanwhile, a dispute has flared up among the indigenous population between opponents and supporters of the timber export. Some see the economic opportunities for the region, others fear for the ecological balance. The sometimes brutal approach of the loggers, who sometimes enter territories without permission, aggravates the social conflicts.

[…] Since the demand for wind energy has been rising in Europe, the USA and Asia, more and more balsa wood is being felled in the Ecuadorian rainforest. For the industry, this is big business: already in the record year 2019, Ecuador exported balsa wood worth 195 million euros; one year later, the value tripled to around 700 million euros. International manufacturers of wind turbines claim that the use of wood is in accordance with local environmental laws and that it is a rapidly renewable resource.”

4.  SOFT DATA

4.1 Economic growth eases to nine-month low as pandemic flares up – IHS Markit

·         Final Eurozone Composite Output Index: 53.3 (Flash: 53.4, Nov Final: 55.4)

·         Final Eurozone Services Business Activity Index: 53.1 (Flash: 53.3, Nov Final: 55.9)

“The accelerated expansion in output we saw in November unfortunately turned out to be brief. Amid a resurgence of COVID-19 infections across the euro area, growth slowed to the weakest since March in December. In Germany, where measures to combat COVID-19 have been more stringent than other monitored euro area countries, levels of economic activity broadly stagnated in December. Nonetheless, slower growth was seen across the board.

“The spread of the Omicron variant had a particularly profound impact on the services sector, reflecting renewed hesitancy among customers due to the novel strain of the virus. Looser travel restrictions in recent months had facilitated greater levels of tourism, which in turn provided additional support to the eurozone service sector. However, this was withdrawn in December as overseas demand declined for the first time since May.

“There was also little to cheer with regards to inflation. Although there was a marginal easing of price pressures, we’re still in excessively hot territory – increases in both input and output costs were the second quickest on record.

“As euro area nations deal with the latest developments in the pandemic, it’s clear that risks to the economy are now greater as tighter restrictions to curb the spread of COVID-19 are more likely than they have been recently.”

Comment: Growth slowing is back. Peak growth is clearly behind us. In this case we’re witnessing that omicron is hurting already broken supply chains. Germany’s composite PMI fell to 49.9, which means the country is close to contractions.

Joe Hayes, senior economist at IHS Markit, warned: “It’s clear that risks to the economy are now greater as tighter restrictions to curb the spread of Covid-19 are more likely. “The spread of the omicron variant had a particularly profound impact on the services sector, reflecting renewed hesitancy among customers due to the novel strain of the virus,” he said. “Looser travel restrictions in recent months had facilitated greater levels of tourism, which in turn provided additional support to the eurozone service sector. However, this was withdrawn in December as overseas demand declined for the first time since May.”

Melanie Debono at Pantheon Macroeconomics said economic growth was likely to have slowed to 0.6pc in the final quarter of 2021, representing the weakest expansion since the start of the year when the eurozone’s economy was shrinking in the winter lockdown. She expected growth will slump further to 0.2pc in the first three months of 2022.

5.  STABILITY PACT

5.1 Emmanuel Macron is a risk for Europe – WELT

[…] But Macron also wants to push through his own ideas in the coming months. He has called a special EU summit for mid-March, which is to adopt a “new growth model” for Europe – a highlight of the French EU presidency. This now poses immense risks for the German taxpayer.

It is to be expected that Macron will try to score points with a bang in the hot election campaign phase. At this EU summit, it is likely that a joint declaration will be made on the softening of the Stability Pact, which in future will only define individual debt targets. From the French point of view, this would be the end of the German stability dictate.

This is in France’s interest: the country recorded new debt of 153 billion euros this year, which is 5.3 per cent of economic output (GDP) – twice as much as Germany. France’s total debt is around 115 percent of GDP (2.8 trillion euros), almost a fifth more than before the Corona pandemic and double what it was at the turn of the millennium.

All countries in the Eurozone are actually required to have 60 per cent of GDP. In addition, the heads of government are likely to announce in mid-March, under Macron’s direction, that renewed borrowing by the EU Commission, as with the Corona aid, must continue to be possible in special crisis situations – whatever these may be. Such a joint debt was taboo for decades.

Comment: We used this article in today’s European geopolitics newsletter as well as it highlights German concerns in a time when France could “abuse” its presidency of the European Council.

In this case, we’re highlighting one of the major political and economic battles: the stability pact. As we’re getting closer to reforms, it’s interesting to see what the goals are. The goals are “to give more room to national fiscal authorities for stabilization purposes, for public investment, and for spending that contributes to European public goods, while still ensuring debt sustainability”. 

This is pure naivety for one major reason: who can ensure debt sustainability when spending rules are loosened? If this had worked in the past, we wouldn’t need reforms. After all, this mess started way before the pandemic. One example is Italy. What if the country gets a populist government after Draghi? Who’s going to ensure fiscal responsibility when spending is allowed to breach “old” rules. Furthermore, Draghi himself has proven rather profligate during the crisis.

Behind the idea of fiscal rules is the legally enshrined impossibility of standard adjustment mechanisms: Art. 125 TFEU precludes bailout; the treaties have no provision for exit; and the euro area can probably not survive a large sovereign debt default. If you soften the rules, something will have to give.

Additionally, without strict rules, a fiscal union is impossible. What Franc – and Italy – are likely pushing for is a plan B, which consists of softer rules accompanied with partial debt monetization through the central bank or a debt agency. That’s unlikely to be sustainable.

As the most extremely proposals are unlikely to survive, it is more likely that the 60% debt of GDP rule will be hiked to 100%. This would reflect the higher debt levels in the euro area (it’s impossible to bring these back to 60% anyway) and incorporate what is expected to be a long-term prior of low interest rates going forward.

The 3% deficit rule will likely remain in place, although countries will try to find options to exclude investments in “green” initiatives and economic transformation, in general. However, this could mean that investments are reclassified and a decline in the quality of investments.